Decentralized Finance (DeFi) - What It Is and Why I'm Interested

After graduating with a degree in economics, I fell into the world of finance. Over the last five years, I've worked for hedge funds, VCs, investment banks, and even large financial institutions. The world of Decentralized Finance (DeFi), therefore, comes as a natural interest to me. DeFi promises to streamline the traditional, centralized banking sector by removing the need for human interference.

Coinbase, for example, has accrued a market capitalization of roughly $50B by running a lean operation with only 1,700 employees. This pales in comparison to the likes of Goldman Sachs ($125B market cap) and Wells Fargo ($185B market cap), who have 40,000 and 235,000 employees, respectively.

Uniswap is a decentralized exchange (DEX) that takes things even further. With only 33 employees, it currently generates around $4M of revenue in fees per day. That's around $1.5B of annual revenue or $46M of revenue per employee per year. Goldman Sachs and Wells Fargo, meanwhile, generated $44.6B and $72.3B in 2020. That's just $1.11M and $307K per employee.

How does DeFi work?

The traditional banking sector is centralized. They have boards of directors, CEOs, and employees who decide whether or not you should get a loan and what happens with your money.

Decentralized protocols, however, are controlled by their communities. Their founders remove themselves from positions of power and let their users vote on the future of the network and the programming of its smart contracts.

One of the ways banks make money is on "net interest margin." Customers deposit cash, and banks then lend this out to their other customers and businesses. They charge these borrowers a higher rate than they pay out to depositors and pocket the profit. The bank's executives and shareholders then collect these profits.

DeFi applications, however, distribute their earnings to their users through their native cryptocurrencies and tokens. By rewarding their users and giving them upside, as demonstrated by Uniswap, not only are these institutions more equitable than traditional banks, they are also more efficient.

Is DeFi Useful?

The efficiency of DeFi applications means anyone in the world can now access financial services. Currently, 1.7 billion people are unbanked — without an account at a financial institution or through a mobile money provider. Approximately 90% of those people without bank accounts own a smartphone.

It's clear to me, therefore, that DeFi has the potential to open up necessary financial services for millions, if not billions. This includes the ability to borrow funds, take out loans, deposit funds into a savings account, or trade complex financial products, all without asking anyone for permission or opening an account anywhere.

Moreover, blockchain technologies, smart contracts, DeFi, and Decentralized Autonomous Organizations (DAOs) have opened the door for a whole host of new and disruptive financial institutions and products to be built.

DeFi and Ethereum

Ethereum is a blockchain network with its own native cryptocurrency, Ether (ETH). Ethereum enables two types of transactions: transfers and computations. Transfers on Ethereum move ETH from one crypto wallet to another, while Ethereum's computation layer lets its network run the code built into smart contracts.

Ethereum's open-source and blockchain-based computation layer is what makes the Ethereum network so powerful. Developers can create and publish smart contracts and build and monetize distributed applications (dApps). These can be used without the costs, risks, and interference associated with third parties and intermediaries. As a result, the Ethereum network is the most popular for building DeFi applications.

The diversity of dApps already built on Ethereum is astounding. In addition to DeFi, there are dApps for gaming, arts and collectibles, technology, and much more. DappRadar has even created a constantly updated list of the most popular Ethereum dApps. This has helped Ethereum become the fifth largest banking institution globally, with a market cap of around $200B.

What are some types of DeFi applications available today?

Lending and Borrowing protocols use smart contracts to eliminate the role of banks. Users can post a wide variety of assets as collateral and borrow other cryptoassets against them. Popular protocols like Aave and Compound remain solvent by liquidating the borrower's loan if their collateral value goes below a specified loan-to-value ratio.

Decentralized exchanges (DEXs) let two parties directly exchange cryptocurrency and are gaining traction amid the exclusion of middlemen and brokers. DEXs aim to solve the problems inherent in centralized exchanges, including the centralized custody of assets, geographic restrictions, and asset selection. Popular DEXs like Uniswap and Sushiswap use automated market-making systems rather than traditional order books. This means users can deposit their assets into a pool to provide liquidity passively. This liquidity is always available for traders and helps make markets for any asset on Ethereum.

Stablecoins are cryptocurrencies that aim to peg their price to another asset. This could be to fiat currencies, like the Dollar or Euro, other cryptocurrencies, or precious metals. Popular stablecoins like USDC and DAI are both pegged to the Dollar. Their stability makes them easy to use for transactions and offers a borderless payments system that is faster, cheaper, and more secure than traditional networks like SWIFT. The most popular stablecoins are either fiat-collateralized (USDC, for example, is backed by the Dollar) or crypto-collateralized (DAI is backed by ETH).

Prediction markets are platforms created to trade the outcome of events, like games or elections. The market prices can indicate what the crowd thinks the probabilities of an event are. Unlike their centralized counterparts, decentralized prediction markets end the role of the middleman and are built on public blockchains. This means no single authority controls them, making them cheaper, more secure and flexible, non-custodial, and censorship-resistant. Prediction markets are yet to gain the popularity of the applications mentioned above, but some notable projects include Augur and Gnosis.

In addition to the four types of applications I've explained above, Tokeny and defiprime have laid out the DeFi ecosystem and the hundreds of applications available today much better than I can do justice. They include things like Derivatives, Synthetic Assets, Asset Management Tools, Insurance Platforms, and KYC & Identity.

What DeFi projects am I following most closely?

Polygon

Ethereum generates money by charging its users fees to use its dApps. These fees depend on the amount of computational power used to execute the smart contracts used by the dApp. However, running this code can be very computationally intensive and result in extremely high fees, which have previously exceeded $100 per transaction.

Coupled with the time delay required to execute Ethereum's smart contracts, these high fees are the most significant roadblocks to the broader adoption of the Ethereum network. To "make Ethereum more scalable, more secure, and more sustainable" and solve issues related to speed and cost, the Ethereum team is currently working on a highly anticipated "Ethereum 2.0" upgrade. The upgrade is expected to roll out across 2021 and 2022 incrementally.

Until then, Polygon is a sidechain that helps solve Ethereum's scaling problems. It runs its own transactions and validates these with its own Proof of Stake system. Instead of validating each transaction, blocks are rolled up into checkpoints that are occasionally committed to the Ethereum blockchain. This makes transactions faster and cheaper; Ethereum's average block time is around 13 seconds, while Polygon's is less than 1 second; Ethereum's average transaction fee is currently $5, while Polygon's are less than one cent.

What makes Polygon so cool is that its 3rd party Proof of Stake validators put up their own capital to provide the computing power required to support the network. In exchange, they receive rewards in the Polygon network's native token, MATIC. They do this because they believe Polygon can grow the number of transactions on its network. This drives the demand for the MATIC tokens they earn. They can then sell the tokens or hold them and hope they appreciate.

Compare this to a centralized business. They would have built their business on an expensive cloud computing platform like AWS, hired a big team, and had the CapEx (buildings, desks, printers, and coffee machines) to support them. To finance this, they'd need to raise a shit load of money and spend a bunch of time traveling between arduous investor pitches.

While Ethereum works out its problems, unsurprisingly, Polygon has seen massive adoption. The number of transactions conducted on the platform and its token price have surged, and there are now over 350 DeFi projects in Polygon's ecosystem.

It's unclear whether this trend will last, however. Layer 2 solutions and other ETH 2.0 advancements like sharding could mark the death of sidechain solutions like Polygon.

Polygon's proponents will argue that Ethereum's network will never be as quick as other blockchains, like Solana, and that there will always be room for Polygon to make things cheaper and faster. But, because Polygon is a sidechain and not a true Layer 2 solution, Polygon's detractors will state that the trade-off in security isn't worth the financial savings.

Polygon's future, it seems, rests on the shoulders of Ethereum's team and their ability to execute their much-awaited 2.0 upgrade, and I'll be keeping a close eye on this space!

Arbitrum

Arbitrum is a Layer 2 rollup. It runs Ethereum's smart contract computations on its own network and then sends the net result back to the main Ethereum blockchain. In other words, these computations are processed "off-chain." In doing so, like Polygon, Arbitrum helps reduce Ethereum's high gas fees. When compared with Polygon, however, Layer 2 rollups like Arbitrum have added security benefits.

Multiple validators process the off-chain computations conducted by Layer 2 rollups. Therefore, the data these validators send back "on-chain" to the main Ethereum network should be the same. If the data isn't the same, Arbitrum will correct the erroneous data directly on Ethereum main chain and resolve the issue.

The fact Arbitrum resolves such issues directly on Ethereum means it has greater security than sidechains like Polygon who independently resolve these issues. Arbitrum, therefore, reduces Ethereum's transaction costs and increases transaction speed while keeping its security layer.

The main issue with Arbitrum is that it's a separate network from Ethereum. This means apps on Arbitrum can't operate with apps on Ethereum. You wouldn't be able to store your money on an Ethereum app and borrow against it on an app in the Arbitrum network, for example.

Nevertheless, Arbitrum shows great promise. Having only been released to the developer community a couple of weeks ago, Arbitrum is still in its very early stages. I'm interested in seeing whether anything will break as it gets adopted by the public or whether hackers will exploit anything.

Conclusion

DeFi is new and needs a lot of infrastructural improvement to avoid hacks and gain mass adoption. Despite this, DeFi use has been increasing in various businesses and applications, and its prospects appear bright. I draw analogy to the cloud storage revolution of 2006 and expect DeFi to make a significant impact on our daily life and business activities.

I'd love to hear from you!

What are your thoughts on DeFi? Will it be the future of finance, or is it all just a big bubble? Which projects are you following most closely? Would you like to hear more from me on Crypto, DeFi, and DAOs?