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The first cryptocurrency Bitcoin is still the most well-known application of blockchain, but this technology has since then slowly expanded and is starting to show promise in other areas. The initial hope with Bitcoin was to make both money and payments universally accessible. The next step is Decentralised Finance (DeFi), also called Open Finance. The visionaries see this as an open-source alternative to every financial service you use today: from savings, loans, trades, to insurance and even more, all globally accessible.
So what exactly is DeFi?
One of the biggest trends this year is the growth of decentralized finance (DeFi), which is an emerging class of cryptocurrency projects that use blockchain to offer new types of lending and market making services without financial intermediaries.
In short, DeFi takes components of centralised finance and decentralizes them by removing middlemen and replacing them with smart contracts and tokens.
What are smart contracts?
Because smart contracts are the basis of DeFi, let’s briefly discuss them first. A smart contract is a digital middle person; they allow the transfer of anything of value in a transparent way. The Ethereum network is currently the blockchain of choice for building smart contracts. If you have something to sell, like your house, you can set a contract holding your digital deed. And when the smart contract receives as inflow, of let’s say a sufficient amount of bitcoin, into a digital escrow, the deed is released to the buyer immediately and you receive said bitcoin. Smart contracts can be programmed to receive and redistribute any digital asset with a specific rule criterion (e.g., enough bitcoin?), while the transaction is recorded on a public blockchain ledger preventing any dispute of ownership. This system saves on the fees that would be charged by, and is in fact more secure than, an escrow service. Smart contracts are far more sophisticated in their functionality than only sending and receiving cryptocurrency, which gives them their advantage: they can deploy a customised financial application or product which is simple and secure to use. These financial application programs are called decentralised apps, or Dapps.
What is being done with DeFi currently, and what are some examples of DeFi Dapps?
Some Dapps that are gaining traction:
All of these Dapps are apps built on decentralised blockchain technologies, rather than those built and controlled by a single, centralised entity or company, like a bank. Though described as ‘decentralised’, it is not truly so. Elements of the current blockchain ecosystems are heavily centralised, and the contracts are created centrally. It may be better understood as non-custodial, in essence meaning it is not necessary to trust a third party.
Why is DeFi a big deal for the finance industry?
DeFi apps can potentially take the place of many custodial banking functions. Rules for DeFi Dapps are written in code and must be followed for the transaction to continue, removing the requirement for a custodian. Once the contract is deployed to the blockchain, a DeFi Dapp can run itself without the need of human intervention, besides the occasional upgrade or improvement to the Dapp.
DeFi is growing like crazy, according to Dune Analytics. Popular protocols have collectively grown more than 23% since June 1, 2020. Token pool protocol ‘Balancer’ has grown more than 580%, adding more than 7,000 new users. DeFi observers measure traction of the DeFi space with a unique new metric ‘Total Value Locked in DeFi’. As of July 2020, users have deposited over 2.2 billion USD worth of crypto into these smart contracts, up from 750 million USD 90 days prior, or nearly 200%.
Total Value Locked in DeFi 90 days ending July 9th, 2020
Where are Dapps and DeFi going in the future?
Since the advent of money humans have had a need for some type of financing system. Cryptocurrencies and blockchain technologies are just the most recent evolution stemming from this need. We can think of cryptos as the coins that were minted and the first smart contracts as the ridges on the coins’ edges to keep people from filing off the gold flakes.
This space is ripe for growth, as you have already seen with the speed at which it has done so in the past 90 days. There is predicted to be unbelievable growth going forward, which some liken to the late 1990s tech boom.
The ability to democratise banking services worldwide obviously has generated huge interest among those that don’t have access to these services currently. In the US, 25% of households are unbanked or underbanked, and worldwide this number is estimated to be at 1.7 billion adults. The current powers that be in the finance world do not want to lose their power, so it will be an interesting struggle between the two groups going forward.
The fiat-crypto chimera. In the near future we will probably start to see governments or their central banks create blockchain-fiat monetary systems. The Chinese seem to be the closest at this current time with their digital yuan called the Digital Currency Electronic Payment (DCEP).
More of the same but better. There are already DeFi Dapps created for: asset issuance and exchange, borrowing, lending, custody, and derivatives. These first generations Dapps were built for and by blockchain enthusiasts. They do their job, but not easily, and not well. The now second generation is adding in the design and functionality lacking in the first. This will attract more users to the space.
Undercollateralised and unsecured borrowing and a credit rating system. The first generation of DeFi Dapps mainly use crypto collateral as a safeguard, or a collateralised debt position (CDP), which are overcollateralised. Essentially if you want to borrow you need to already possess crypto. Going forward we will see more undercollateralised, as well as entirely unsecured, borrowing and lending come into the DeFi space. Bankers will potentially be cut out of one of their most profitable businesses. It will probably start with undercollateralised loans likened to a mortgage with 20 percent down. This type of lending will have to rely on some form of an identity system, allowing borrowers to build up credit and increase their borrowing power like with the FICO scores of today, but instead all of the data will be recorded on the public blockchain. The crucial objective in this regard is that a decentralised identity will have to be both universal and privacy-preserving.
Growth in DeFi insurance. As stated the current DeFi loans are overcollateralised and are being held in digital escrows. There is potential that the system could be hacked and the money or digital goods stolen. One of the first companies offering tokenised insurance is Nexas Mutual. They will insure smart app transactions as are other companies like Etherisc and CDx. This is likely to be a quickly growing segment once other insurers jump into the space.
Movement to cryptos from currencies with hyperinflation. Residents of countries that have hyperinflation will likely be the first to move to a more stable digital currency. It may originally be black market trading that happens but there are currently all of the needed parts in place for users with a smartphone and an internet connection to take advantage of this opportunity.
The word decentralised will start to mean something. Governance and decision-making will be decentralised, allowing stakeholders to have a say going forward. Also, many projects today have master keys for the developers to shut down or disable Dapps, which was done for updates and emergencies. This will slowly end and the switches will be removed.
Crypto to fiat and back in a DeFi Dapp (noncustodial) way. The process of moving from a fiat currency to a digital currency quickly, with ease, and in a non-custodial way will have a place in this system as well. Coinbase is the first platform to take a step toward this end, allowing DeFi interest Dapps to be incorporated into its wallet. However, getting it to a bank account still requires an ACH transfer needing approximately 3-5 business days and Coinbase charges a 1.49% fee. Gemini is charging 0.002BTC (roughly 18 USD) for more than 10 ACH transfer withdrawals a month. Trading crypto for cash is also done with services like localbitcoins.com, but it is still not simplified and requires a real-world peer to peer exchange. If there is an exchange/conversion system that is as easy and quick as say Zelle, while also being non-custodial, that would be very useful.
Summary
The current financial system is ready for change. It started slowly with Bitcoin initially bringing money online into a decentralised system which halves its inflation rate every four years. We are now in the next phase of blockchain development and are starting to see what is possible in the Dapp space. Many services that were only available through the trust earned by legacy banks and other financial institutions have begun to shift. If the general public is already accustomed to banking and buying online, they may be attracted to even cheaper and just as reliable non-custodial financial solutions that they can trust. The DeFi field has grown at a nearly unbelievable pace in just the past three months. We are seeing a new boom in the works. This is a rare opportunity, and when given such a rare opportunity we are remiss not to take it. The pioneers of DeFi have a mighty task to catch up to institutions that have been around for a very long time and want to defend their place. Over time we will see innovations democratising and disrupting our current financial services system.
Disclaimer: The author of this text, Jean Chalopin, is a global business leader with a background encompassing banking, biotech and entertainment. Mr. Chalopin is Chairman of Deltec International Group, www.deltecbank.com.
The co-author of this text, Robin Trehan, has a bachelor’s degree in economics, a master’s in international business and finance, and an MBA in electronic business. Mr. Trehan is a Senior VP at Deltec International Group, www.deltecbank.com.
The views, thoughts, and opinions expressed in this text are solely the views of the authors, and do not necessarily reflect those of Deltec International Group, its subsidiaries, and/or its employees.
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