There has been plenty of hype, chatter, doubt, confusion, and enthusiasm around decentralized finance, or “DeFi,” the blockchain-based network of products and services that swaps traditional financial intermediaries for software that is open to all, autonomous, and transparent.
Although DeFi is still in its early stage — only a few years old — the economy around it is already sizable and important: Ethereum, the backend infrastructure for DeFi, settled roughly $1.5 trillion in transactions last quarter, or 50% of Visa’s payment volume; decentralized money markets are extending billions of dollars in loans each month; and people and companies are using platforms like the Uniswap protocol to trade volumes at about 30% of Coinbase’s size. [Disclosure: I work for Uniswap Labs, which helped invent the protocol.]
Because entrepreneurs, corporate executives, policymakers, and institutions large and small are paying so much attention to this trend, I will attempt to describe DeFi’s features and advantages, lay out some of the hurdles ahead, and assess the path toward broad acceptance and adoption.
But before that, what made it possible in the first place?
What is DeFi and where did it originate?
DeFi is built on three major waves of blockchain progress over the past decade, and each wave began amid deep skepticism before moving toward acceptance and adoption.
The first era was defined by Bitcoin (invented in 2009), which gave us the distributed ledger, or blockchain, designed to facilitate peer-to-peer transfers of a non-sovereign digital asset. The second wave was defined by Ethereum, which drew from the same underlying distributed, censorship-resistant architecture: however, unlike Bitcoin, Ethereum’s native programming language (Solidity) can be used to create any conceivable application, transforming it into a globally accessible supercomputer. The third wave was the initial coin offering boom of 2017, which financed a range of projects, some of which have started delivering on their promise of a decentralized financial ecosystem.
DeFi is the fourth wave, and it rests on a blend of these innovations.
With DeFi, anyone anywhere can lend, borrow, send, or trade blockchain-based assets through simple downloadable wallets, without needing a bank or broker. If they choose, they can also try more advanced financial activities — leveraged trading, structured products, synthetic assets, insurance underwriting, market making — while still keeping full control of their assets.
DeFi protocols follow key standards — especially permissionless-ness and transparency — that reflect the values embedded in Ethereum, the open-source decentralized software platform that underpins most decentralized applications.
“Permissionless” applies both to users and to developers: DeFi applications can reach anyone in the world who has an internet connection, no matter ethnicity, gender, age, wealth, or political affiliation. In addition, any group of developers can build on these platforms with confidence, knowing that no central authority can later revoke access.
“Transparent” means the capital and code can be audited by design: Because the software is always source-available or open source, all of the underlying code remains continuously available for review, and all associated capital is open to inspection. Every transaction is recorded on a blockchain, making it easy to review specific transactions or for businesses to study the data for investment or even investigative purposes.
What are the features and benefits of DeFi?
DeFi’s two core traits — permissionless-ness and transparency — lead to several powerful use cases.
Lowers barriers to entry, slashes switching costs, provides optionality
The permissionless character of Ethereum-based applications — along with the freedom to easily and seamlessly “fork” (or copy and adapt) codebases — drives barriers to entry for entrepreneurs all the way down to zero. Consumers are the main winners in this innovative setting: Since all applications use the same database, the Ethereum blockchain, shifting capital from one platform to another is simple. That forces projects to compete intensely on fees and user experience.
A useful example is the growth of “exchange aggregator” applications: With public APIs, these aggregators connect to several liquidity venues, splitting orders across platforms to give users the best possible exchange rate. In only a few months, such aggregators have sped up DeFi’s movement toward best execution, a standard that early electronic markets needed formal regulation to reach.
Compare DeFi’s competitive markets with consumer banking today, where opening and closing accounts can take three days. Or compare DeFi with the brokerage industry, where moving securities between platforms can take up to six business days and many phone calls. Along with other burdensome terms, these are the “switching costs” that keep consumers from taking their business elsewhere, even when services are worse. In fact, to the detriment of retail consumers, traditional finance is heading in the exact opposite direction, with the number of bank charters falling at an annual rate of 3.6% since 1990, reducing consumer choice.
Transparent accounting, rigorous risk assessment
The auditable nature of capital reserves in DeFi makes rigorous risk assessment and risk management possible. For decentralized money markets and credit facilities — repo-like platforms that let users enter variable-dated, peer-to-peer, secured-lending arrangements — users can examine both the quality of the collateral portfolio and the amount of leverage in the system at any moment.
Compare that with the opaque nature of the current financial system. It was only after the global financial crisis of 2007-2008 that analysts and regulators started to realize that the ratio of loans to deposits in the U.S. had reached 3.5… twice the ratio in the second most highly leveraged banking system, Russia.
Aligns incentives, solves principal-agent problem
Using trustless, programmable escrow accounts, commonly called “smart contracts,” enables DeFi protocols to build in recourse at the protocol level.
For instance, in the MakerDAO system, a decentralized credit facility, MKR token holders earn interest that borrowers pay. But if insolvency or defaults occur, they act as the main backstop: MKR is automatically created and sold into the market to absorb losses. This programmatic enforcement produces very strict accountability, forcing MKR holders to choose sensible collateral and liquidation risk parameters. The alternative — lax risk management practices — leaves MKR holders exposed to dilution.
By contrast, in conventional finance, shareholders are the ones who suffer directly when management errs. The recent Archegos collapse is a current example: although several senior executives at Credit Suisse departed the bank, they were not personally made liable for the losses. In DeFi, by comparison, direct accountability would lead to improved risk management.
Modern infrastructure, increased efficiency of markets, robustness
Ideally, capital ought to move as effortlessly as information does in the internet era. More specifically, settlement should happen instantly, transaction costs should be very low, and services should be available 24/7/365: 24 hours a day, 7 days a week, 365 days a year. It is simply not productive for the global financial system to run only from 9 to 5, except for weekends and holidays.
There is plainly unmet demand for updated settlement infrastructure, as evidenced by Ethereum settling $1.5 trillion in transaction volume last quarter, up from $31 billion in Q1 2019. We also recently witnessed the kind of market disruption that can arise when settlement is not instantaneous: Robinhood was briefly required to halt buy orders for GameStop because it had trouble meeting capital requirements, which are themselves a result of T+2 settlement (the industry standard under which transactions usually take two days to clear).
Efficient markets likewise depend on resilient infrastructure. The distributed design of blockchains makes them remarkably robust: in the six years since Ethereum launched, the network — and, by extension, the applications built on it — has recorded 100% uptime. The same cannot be said of centralized equivalents. Even when they are centralized, longstanding, and/or regulated, these centralized entities — whether exchanges or payment networks — can prove unreliable, particularly during periods of high volatility.
The impact on consumers is very real. Consider brokerage customers who log in later and discover that their balances have dropped sharply.
Global access, unified markets
Markets that are inherently international can draw on a broader liquidity pool, sharply lowering transaction costs for everyone involved.
Today, decentralized exchanges can provide more favorable exchange rates for some assets than segmented centralized exchanges or service providers. In equity markets, tools such as American Depositary Receipts (ADRs) are used to connect investors to foreign exchanges, yet they often carry large premiums and limited liquidity.
When markets are accessible worldwide, they can also increase financial enfranchisement. At present, developing countries are frequently shut out of financial services because the expense of establishing local operations is high relative to demand, infrastructure is lacking, and more. But decentralized financial services — internet-native services with zero-marginal-user costs — can reach marginalized groups, offering access to services such as insurance, cross-border payments, dollar-denominated savings accounts, and credit.
Real-time data
One consequence of building financial services on a transparent, shared database is that all related transaction data is publicly visible in real time. For instance, earnings earned by liquidity providers in the Uniswap Protocol can be monitored down to the second. Investors can rely on this information to determine how to deploy capital, enabling more efficient price discovery and resource allocation, while regulators can watch real-time transaction data to spot malicious user behavior.
This marks a major break from traditional capital markets, where investors are kept completely in the dark until companies publish quarterly earnings reports. The condition of private markets is even worse, with firms often creating their own accounting metrics, if they choose to disclose metrics at all. It is hard to imagine investors making rational choices when they must rely on stale information! Regulators also have a difficult time in the current system, waiting years to uncover misconduct, by which point it is often too late to fix; Greensill Capital and Wirecard are two recent case studies.
Elimination of counterparty/ credit risk, lower compliance overhead
By definition, DeFi platforms are “self-custodial”: users never give custody of their assets to a centralized operator. Although that may initially seem daunting to some people, the self-custodial structure of DeFi helps remove counterparty and credit risk — the risk that a party in a financial transaction defaults or fails to meet obligations on a trade or loan. Analysts estimate that more than $7B worth of cryptocurrencies has been lost through centralized exchanges since 2011, whether because of hacks or because operators deliberately disappeared with user funds. DeFi represents a paradigm shift, moving from “don’t be evil” to “can’t be evil.”
Self-custody is just as beneficial for operators, who can free themselves from needless liability and compliance overheads: for example, FinCen’s cryptocurrency guidance says companies that custody user funds must obtain money transmitter licenses, a usually arduous process, whereas those that engage with self-custodied wallets can operate without.
Challenges to mainstream adoption
As with any new and developing technology, DeFi still faces challenges. This is similar to the early internet, when connections were slow, hardware was costly, and even the brightest innovators found it hard to support the idea of images or video, which are now the very currency of online social activity.
Scaling
The underlying backend infrastructure for DeFi, Ethereum, has to keep scaling in order to handle greater bandwidth demand. With roughly 1.5 million unique transactions processed each day, Ethereum is already operating at its present maximum capacity, and transaction fees have risen as a result.
However, scaling must not happen at the cost of security and decentralization. After years of intensive R&D, multiple scaling solutions are now close to launch, promising to ease Ethereum’s burden while preserving its core value set. Scaling will likely always be a fairly gradual process, with new capacity added to meet excess demand on an ad hoc basis. (This, too, is not unlike the evolution of the internet.)
Better onboarding
The DeFi onboarding experience is still too daunting for the average user. Moving fiat money (dollars, euros, sterling, etc.) into the crypto economy remains highly frictional, with fiat on-ramps still confined to certain geographies and processor fees uncompetitively high.
Even after fiat has been converted into crypto assets, custody and wallet management can still feel intimidating: specialized “wallets” have to be installed to interact directly with the Ethereum network — many requiring users to protect highly sensitive passwords, private keys, and seed phrases — without the reassurance of “forgot your password?” backups. There is no remedy if they are misplaced.
There is still cause for optimism, though. The sector is moving toward better custody and wallet standards: for example, Argent, a “smart wallet,” does away with seed phrases altogether and gives users both daily spending caps and a smooth “social” recovery path if devices are lost. I expect the fiat on-ramp market to grow more competitive over time, with fees, availability, and processing speed improving accordingly.
Clear regulatory framework
Global regulators have plenty to handle as technology disrupts new markets. In finance alone, today’s regulators are contending with many kinds of fintech, from neobanks and crowdlending to gamified stock trading.
Blockchain technology is one area that the traditional financial world, and regulators too, ignored or brushed aside for years. Now those regulators are examining the technology, the markets, and the participants in order to determine the right rules. Their objectives are to provide enough transparency for users and law enforcement where such transparency does not already exist; to focus on fraudulent conduct while discarding the earlier belief that all blockchain-based activity was fraudulent; and to safeguard freedom of expression and privacy for consumers.
Still, over the years many policymakers and regulatory bodies proposed cryptocurrency rules that would have choked off each earlier cryptocurrency wave, despite the possible pro-consumer upside. Instead, they zeroed in on the negative — illicit finance with bitcoin, risky investing with Ethereum and early token sales — often without seeing the much larger benefits.
As a consequence, some regulatory proposals misconstrue DeFi — both the roles of the various actors and the technology itself — and would impose liability and burdens far beyond existing law, even on largely uninvolved software developers. Such proposals are comparable to trying to make the inventor of SMTP answer for every spam email ever sent, or holding the inventor of HTTP responsible for every illegal website.
Appropriation of decentralization
In a very similar way that “private blockchains” were the result of incumbents wrongly trying to absorb earlier blockchain waves, there is a danger that centralized financial institutions will absorb the DeFi movement, making substantial concessions in the process. Although they may look much like other smart contract blockchains such as Ethereum, some of these chains are effectively centralized, relying on users caring about speed and low fees — while giving up the permissionless, neutral, and immutable assurances that are at the core of the DeFi value proposition. While it may be true that “weak” versions of a technology often appear with every tech trend alongside the strong versions, as Chris Dixon has argued, this is not really a case of weak forms of the technology but of deceptive marketing, an old wolf in new sheep’s clothing.
It is easy to picture some traditional financial institutions, such as commercial banks, major tech companies, or even nation-states, deciding that rather than learning how to adopt or integrate DeFi, they will pursue the misleading or weaker version instead. And while those offerings may deliver incremental gains in efficiency, they will not achieve the technology’s full promise: worldwide, permissionless access to global liquidity and the complete removal of counterparty risk.
* * *
DeFi is here, and it is here to stay. Some skeptics see it as an idealistic movement, fated to remain in the shadows of the internet forever. But because of its new advances in settlement efficiency, risk management, and accessibility, DeFi is likely to become a core part of financial infrastructure not just for cryptocurrencies, but also possibly for every other kind of market: in the not-too-distant future, people will sell tickets, Apple stock, pork belly futures, socks, and much more through DeFi protocols, likely with portals that provide access to that infrastructure under separate regulatory regimes and business operations.
That will not mean the end of the existing financial services industry, as some hardline supporters may claim, just as the internet did not completely eliminate print. But the opportunity in DeFi for traditional financial services and other companies will lie in letting them concentrate on their main structural strengths — custody products, prime brokerage, fiat on-ramps, customer service, and so on — while obtaining liquidity and products directly from decentralized protocols.
Early skeptics once said that nobody would use or value bitcoin; in a little over a decade, it has grown into a trillion-dollar asset competing with gold, and it is now held on the balance sheets of several public companies. In the same way, critics claimed Ethereum would not work, was too slow, and was too costly. Today Ethereum supports thousands of permissionless applications, has settled trillions of dollars worth of transactions, has served as infrastructure for legacy financial giants, and has made a major contribution to cutting-edge cryptography research. And even with the failures of the ICO boom, many token sales financed the development of extraordinarily important technology, including decentralized storage (a long-sought holy grail in computing), network interoperability, manipulation-resistant data feeds, and decentralized computing.
Most importantly: each of these crypto waves attracted tens of thousands of engineers and entrepreneurs, and that is exactly how the future of DeFi will be built.