What is DeFi?
DeFi (pronounced dee-fye) stands for decentralized finance. It’s an umbrella term for the part of the cryptocurrency universe that is geared towards building a new, internet-based financial system that uses blockchains to replace traditional intermediaries and fiduciary mechanisms.
I am falling asleep.
Do not! I promise it’s very interesting.
OK, I’ll give it a chance. What do you mean by “using blockchains to replace traditional intermediation and fiduciary mechanisms?”
Let’s back up a bit. To send or receive money in the traditional financial system, you need intermediaries, like a bank or a stock exchange. And to feel comfortable doing transactions, all parties need to trust that those middlemen will act fairly and honestly.
In DeFi, those middlemen are replaced by software. Instead of trading through banks and stock exchanges, people trade directly with each other, with blockchain-based “smart contracts” that do the work of creating markets, settling transactions, and ensuring that The whole process is fair and reliable.
So is DeFi a cryptocurrency version of a stock exchange?
That’s part of it. But DeFi also includes things like lending platforms, prediction markets, options, and derivatives.
Essentially, crypto users are building their own version of Wall Street – a largely decentralized and exclusively traded version of crypto, with crypto versions of many products. products offered by traditional financial firms and without many red tapes and regulations governing the existing financial system.
Wall Street Wild West! OK, now I care. How big is DeFi?
According to DeFi Pulse, the total value of locked DeFi or TVL – a standard way of measuring the value of cryptocurrencies held in DeFi projects – is currently around $77 billion. That would make DeFi the 38th largest bank in the US in terms of deposits, if it were a bank.
So not big, but not small either.
It’s correct. And TVL isn’t the only way to measure DeFi’s growth. You can also look at trading activity on decentralized exchanges, which has grown in triple digits over the past year.
Or you can get input from regulators and politicians, who are increasingly interested in the development of DeFi. Michael Hsu, U.S. currency calculator, said in a keynote at a blockchain conference in September that many DeFi products remind him of credit default swaps and complex derivatives. other magazines that were popular on Wall Street in the years leading up to the 2008 financial crisis.
And Senator Elizabeth Warren, a Massachusetts Democrat, singled out DeFi during a crypto hearing in December, calling it “the most dangerous part of the crypto world.”
Why are people worried about DeFi?
In short, since DeFi is largely unregulated, there are few consumer protections and safeguards that exist in the traditional financial system.
Can you give me an example of something that would be regulated in the traditional financial system, but not in DeFi?
The best example is probably stablecoins. A stablecoin is a cryptocurrency whose value is pegged to the value of a government-backed currency, like the US dollar.
Stablecoins are an important part of the DeFi market, because if you are a crypto investor, you don’t want to constantly change tokens back and forth dollars or keep all your assets in crypto. whose values can fluctuate wildly. You want a cryptocurrency that behaves like a boring, stable dollar, that you can use without interacting with the TradFi system.
It’s what DeFi people jokingly call traditional finance.
Clever. So let’s get back to stablecoins. What’s dangerous about them?
Well, regulators have argued that despite the name, stablecoins are actually not that stable.
As my colleague Jeanna Smialek explained in a stablecoin article last year, anxiety stems from the fact that stablecoin issuers are not legally required to back their coins one-on-one. with safe assets, like cash. Investors purchasing stablecoins can reasonably assume that each USD Coin or Tether (the two most common stablecoins pegged to the US dollar) is worth $1 and that they will be able to redeem their stablecoins. into real dollars whenever they want.
However, there is currently no provision in the law that requires stablecoin issuers to have their own backing. And if they don’t have enough reserves to cover the stablecoins they’re issuing, the whole thing could fall apart if enough investors decide to pull their money out all at once.
This will happen, especially since stablecoins are the backbone of DeFi trading. And there are questions among investors and regulators about whether some of the top stablecoin issuers actually have enough assets to pay their holders, in the event of a purchase. large scale again.
So stablecoins can be unstable. What else could be worrying about DeFi?
Cryptocurrency companies that issue loans, credit cards, and savings accounts, without many of the protections or safeguards offered by conventional banks, are also causing concern. . Regulators in the United States have begun clamping down on companies that issue these products, arguing that they pose a risk to consumers.
Regulators are also looking at decentralized exchanges, or DEXs, that allow users to swap crypto tokens with the help of market-making algorithms.
And then all the hacks and scams…
Yes. DeFi, like cryptocurrencies in general, is a big target for scams. More than $10 billion was lost to hacks and scams in DeFi projects in 2021 alone, according to a report from blockchain analytics firm Elliptic.
Often the victim of a DeFi scam is not likely to expect much. And unlike conventional, FDIC-insured bank deposits, crypto tokens are generally not replaceable or recoverable once they’re gone.
So let me get this straight. One of the fastest growing areas of crypto is the Wild West version of Wall Street where there are no investor protections, where so-called “stablecoins” can be volatile, and where your money Can you get stolen at any time?
It’s an unflattering but largely accurate summary!
Why are people signing up for this?
First, many people like DeFi because it’s very new and unregulated. Building a whole new financial system from scratch is a kind of intellectual challenge that doesn’t happen every day, and a lot of people are drawn to the open, empty potential of the field. Plus, if you’re a smart trader or an experienced financial engineer, you can do all the things in DeFi that you can’t do in the traditional financial system and potentially earn money. Get a lot of money very quickly.
Second, many DeFi fans argue that blockchain is technologically superior to the current banking system, much of which runs on ancient databases and outdated code. (For example, most banking transactions are still based on programs written in COBOL, a programming language that dates back to the 1960s.) Crypto, they say, was the first truly created form of money. for the Internet, and as it grows, it will need a new, internet-based financial system to support it.
Third, if you’re already into crypto/web3’s vision of a decentralized economy, then DeFi is the financial architecture that can make all the things you’re excited about possible. . There is no way, in the traditional financial system, for the DAO to generate an out-of-the-box membership token and use it to raise millions of dollars. You cannot call JPMorgan Chase or Goldman Sachs and ask them to give you a quote for Smooth Love Potion, which is priced in Dogecoin. (Well, you could, but they might have committed to you.) But with a DeFi platform, you can find people who are willing to trade almost any crypto-asset for almost any asset. other cryptocurrencies without the approval of a central institution.
And fourth, there’s a more ideal cohort of DeFi aficionados who see all of these headlines in a much more utopian direction.
These people say that financial decentralization could help correct the flaws in our current financial system, in part by eroding the power of the big Wall Street banks over the economy. and our market.
How will it work?
These optimists argue that since DeFi replaces human intermediaries and fiduciary mechanisms with public blockchains and open source software, it is cheaper (fewer fees), more efficient (transaction times). translates faster) and is more transparent (less chance of corruption) than the traditional financial system.
They say it democratizes investing, putting tools in everyone’s hands that previously only professional investors had access to. And because you can engage in cryptocurrency anonymously and without bank approval, they say, DeFi is a way to provide financial services to people not served by the conventional banking sector. service and avoid many of the discriminatory practices that have kept minorities from accessing financial services in the past.
Ultimately, optimists say, DeFi will become more secure and robust over time, as more people use it and some of the initial problems are resolved. And just as they believe web3 will replace greedy technology platforms with user-owned collectives, they believe DeFi will replace today’s banks and brokerage firms with a better system. , fairer.
That sounds great, but I’m still worried. Didn’t we learn our lesson in 2008 about the dangers of unregulated finance? Can DeFi Cause the Next Financial Crisis?
Right now, it’s unlikely that DeFi could create any catastrophe on the scale of the 2008 financial crisis. It’s still a relatively small part of the crypto world (which is a relatively small part). overall economy) and many of the people pouring money into DeFi are the type of deep-pocketed investors who can suffer even large losses.
But the possibility that DeFi could grow large enough to pose a systemic risk is not lost on regulators, who are trying to make the Crypto Wild West a little less wild.
“Finance 3.0: DeFi, Dapps, and the Promise of Decentralization” Kevin Werbach, a professor at the Wharton School of the University of Pennsylvania, argues that DeFi will revolutionize the financial world by “removing costly and controlling intermediaries from financial transactions”.
“Has anyone seen Tether’s Billions?” Bloomberg’s report on the mysterious dollar reserves of Tether, the central stablecoin of the DeFi economy, helps explain why regulators are worried.
“The Challenger” This independent media company’s daily DeFi newsletter is an industry must-read.