What is DeFi?
DeFi (pronounced decentralized) stands for decentralized finance. It is a collective term for some cryptocurrencies aimed at building new Internet-native financial systems using blockchain instead of traditional intermediaries and trust mechanisms.
I’m falling asleep.
please do not! I promise it will be interesting.
OK, give me a chance. What does it mean to “use blockchain instead of traditional intermediaries and trust mechanisms”?
Let’s back up a little. To send and receive money in the traditional financial system, you need an intermediary such as a bank or stock exchange. And in order for transactions to be comfortable, all parties need to trust their intermediaries to act fairly and honestly.
In DeFi, these intermediaries are replaced by software. Instead of trading through banks and stock exchanges, people trade directly with each other, ensuring that blockchain-based “smart contracts” create markets, settle transactions, and make the entire process fair and reliable. increase.
So is DeFi the stock exchange version of cryptocurrencies?
That’s part of it. However, DeFi also includes lending platforms, prediction markets, options, derivatives and more.
Basically, crypto people are building their own version of Wall Street. It is primarily decentralized, dealing only with cryptocurrencies, using cryptocurrency versions of many of the products offered by traditional financial companies, with few bureaucratic formalisms or regulations governing regulation. Existing financial system.
Wild Westwall Street! OK, I’m interested now. How big is DeFi?
According to DeFi Pulse, the total value of locked DeFi or TVL (the standard way to measure the value of cryptography held in a DeFi project) is currently around $ 77 billion. If it were a bank, it would make DeFi like the 38th largest bank in the United States by depositing.
It’s not that big, but it’s not too small.
right. And TVL is not the only way to measure DeFi growth. You can also see trading activity on decentralized exchanges that have grown at a triple digit rate over the past year.
Or you can get hints from regulators and politicians who are paying more and more attention to DeFi’s growth concerns. In a speech at the blockchain conference in September, Decentralized Comptroller of the United States, Michael Sue said that many DeFi products were popular on Wall Street in the years leading up to 2008, including credit default swaps and others. Said that it reminded me of the complex derivatives of. Economic crisis.
And Senator Elizabeth Warren, a Democrat in Massachusetts, picked up DeFi at a cryptocurrency hearing in December and called it “the most dangerous part of the world of cryptocurrencies.”
Why are people so worried about DeFi?
In short, DeFi is largely unregulated and has few consumer protections and safeguards that exist in traditional financial systems.
What are some examples of things that are regulated by the traditional financial system but not by DeFi?
The best example is probably stablecoin. Stablecoin is a cryptocurrency whose value is fixed at the value of government-sponsored currencies such as the US dollar.
Stablecoin is an important part of the DeFi market. That’s because if you’re a crypto investor, you don’t want to constantly exchange tokens for dollars or hold all your assets in cryptocurrencies whose values can fluctuate significantly. You need a crypto coin that behaves like a boring and stable dollar. It can be used without having to interact with the TradeFi system at all.
This is what the DeFi people jokingly call traditional finance.
Smart. Now let’s go back to Stablecoin. What are those dangerous?
Well, regulators claim that despite its name, Stablecoin isn’t really that stable.
As my colleague Jeanna Smialek explained in last year’s article on Stablecoin, worry is that stablecoin issuers are legally required to back their coins one-on-one with safe, cash-like assets. It stems from the fact that it doesn’t. Investors buying stablecoins, USD coins or tethers (the two most popular stablecoins fixed in US dollars) are worth $ 1 and can always redeem stablecoins for real dollars. You might reasonably assume that you can.
However, there is currently no law requiring stablecoin issuers to receive one-on-one assistance. And if you don’t have enough reserves to cover the stablecoins they are issuing, and if enough investors decide to withdraw money at once, the whole thing can collapse.
This is especially true because Stablecoin is the backbone of DeFi trading. Investors and regulators also question whether some of the major stablecoin issuers actually have enough assets to pay holders in the event of a large redemption. there is.
Therefore, stablecoins may not be stable. What else are you potentially worried about DeFi?
Cryptocurrency companies that issue loans, credit cards and savings accounts are also worried, without the many protections and safeguards that traditional banks offer. US regulators have begun cracking down on companies that publish these products, saying they could pose a risk to consumers.
Regulators are also considering a decentralized exchange (DEX) that allows users to exchange crypto tokens with the help of market-making algorithms.
And there are all the hacks and scams …
Yes. Like common cryptography, DeFi is a big target for fraud. In 2021, more than $ 10 billion was lost in hacking and fraud on DeFi projects, according to a report by blockchain analytics firm Elliptic.
It’s usually not very reliable for victims of DeFi scams. Also, unlike regular bank deposits guaranteed by the FDIC, cryptographic tokens are usually not redeemable or recoverable once they are gone.
So let’s straighten this. One of the fastest growing areas of cryptocurrencies is lack of investor protection, what is called “stablecoin” may be unstable and your money is irreversibly stolen at any time. A possible Wild West version of Wall Street.
This is an almost accurate summary, to say the least.
Why does someone sign up for this?
First of all, there are many people who like DeFi because It’s very new and unregulated. Building an entirely new financial system from scratch is a kind of intellectual challenge that does not occur every day, and many are drawn to the potential for widespread blank slate in this sector. What’s more, if you’re a smart trader or an experienced financial engineer, you can do all sorts of things with DeFi that traditional financial systems couldn’t, and you could make a lot of money very quickly. there is.
Second, many DeFi fans claim that blockchain is technically superior to existing banking systems. Many existing banking systems run on old databases and old code. (For example, most banking transactions still rely on programs written in COBOL, a programming language dating back to the 1960s.) Crypto was the first form of money actually devised for the Internet. As it grows, it will require a new Internet-native financial system to support it.
Third, if you agree with the crypto / web3 vision of a decentralized economy, DeFi is a financial architecture that allows you to do everything you are excited about. In the traditional financial system, there is no way for DAOs to create spooky membership tokens and use them to raise millions of dollars. You cannot call JPMorgan Chase or Goldman Sachs to request a quote for SmoothLovePotion for sale on Dogecoin. (Well, you can, but they may commit you.) But with the DeFi platform, you can exchange almost any crypto asset for almost every other crypto asset without the need for central entity approval. You can find people who are willing to do.
And fourth, there’s a more ideal cohort of DeFi fans who see all this going in a much more utopian direction.
According to these people, financial diversification can help solve problems in the current financial system. This is partly due to undermining the power of Wall Street’s major banks over the economy and markets.
How does it work?
These optimists are cheaper (fewer fees) and more efficient (faster transaction times) than traditional financial systems, as DeFi replaces human intermediaries and trust mechanisms with public blockchain and open source software. It claims to be highly transparent (less likely to be damaged).
They say it democratized investment and brought tools that were previously accessible only to professional investors into the hands of people. And because you can join cryptocurrencies anonymously and without bank approval, DeFi is a way to provide financial services to people who are not served by the traditional banking sector and avoid many of the discriminatory practices of the past. They say they are a minority from accessing financial services in the past.
Ultimately, optimists say DeFi will become safer and more robust over time as more people use it and some of the early problems are resolved. And just as they believe that web3 will replace greedy tech platforms with user-owned aggregates, DeFi believes that today’s banks and securities firms will replace today’s banks and securities firms with better, fairer systems.
That sounds great, but I’m still worried. Didn’t you learn the lessons of 2008 about the dangers of unregulated finance? Can DeFi cause the next financial crisis?
At present, DeFi is unlikely to cause a disaster at the scale of the 2008 financial crisis. It’s still a relatively small part of the world of cryptocurrencies (a relatively small part of the whole economy), and many of the people who spend money on DeFi are a kind of well-funded investor who can absorb even big losses.
However, the potential for DeFi to be large enough to present systemic risk is not lost to regulators scrambling to keep the crypto wildwest a bit wild.
“Finance 3.0: DeFi, Dapps, and the Promise of Decentralized Disruption” Kevin Werbach, a professor at the Wharton School of the University of Pennsylvania, argues that DeFi will revolutionize the financial world by “eliminating intermediaries from costly financial transactions.”
“Have you seen billions of tethers?” Bloomberg’s report on Tether’s mysterious dollar reserves, a stablecoin at the heart of the DeFi economy, helps explain why regulators are worried.
“Rebel” This independent media company’s daily DeFi newsletter is a must read in the industry.