Leoglossary: Decentralized Finance (DeFi)

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Decentralized Finance (DeFi) is an emerging technology that alters how the financial system operates.

Utilizing distributed ledger technology (DLT), DeFi eliminates the need for intermediaries such as banks, exchanges, or brokerage firms. All financial activity can occur utilizing applications built to facilitate what is needed. This is possible due to the use of smart contracts.

Some of the services that DeFi services can offer:

Decentralized Exchanges

One of the key components of DeFi is the transition away from centralized to decentralized exchanges (DEX). While cryptocurrency is still traded in great quantities through centralized exchanges such as Huobi, Binance, Bittrex, and Coinbase, decentralized exchanges are making great strides.

Some of these are tied to a particular blockchain, thus trading on the native coins. An example of this is on the Hive blockchain. There is a built in exchange which allows for the trading of $HIVE and HBD. This is not done through a third party. All activity through the Hive exchange is tied directly to the blockchain.

The key aspect to a DEX is the lack of an order book. Unlike a CEX, which uses this along with exchange-based wallets, a DEX utilizes the smart contract for peer-to-peer trading. Here we see how the intermediary is removed.

It is the smart contract technology which provides the instructions (code) of how assets are to be managed. The contract dictates the happens on the DeFi platform, not a company.

Blockchain

Blockchain technology is at the foundation of the entire DeFi system.

A blockchain is basically a decentralized ledger. It utilized distributed ledger technology (DLT) to monitor all transactions and ensure the balances of each wallet is properly maintained. Each block contains the transactions, timestamps, and hash tying it to previous block. Once a block is made irreversible, the transactions are basically settled.

Block producers are responsible for validating all the transactions. Once this is done, the node that handles that block updates it own ledger and distributes it out to the rest of the network. The validation is done based upon the consensus mechanism the chain utilizes. The most common are:

Once the blocks are locked in, the transactions become immutable.

DApps

The next layer of DeFi are the applications themselves, call DApps (Decentralized Apps). These are what allow users to engage with the different services being provided.

It is important to mention that, in many instances, the term "DApp" refers to the fact it is tied to something utilizing smart contract technology. The application itself might be decentralized but is probably not. These can be browser plug-ins or downloadable applications. Whatever the format, there is a good chance of a centralized company behind it.

There is also a lot of venture capital money rolling into to fund development of DApps. This is certainly a potential gold mine in the race to control the offering of these services. An application like Metamask is a prime example of a DApp that got in early and became the standard. In this instance, it is a wallet for engaging with the Ethereum blockchain along with the different EVMs.

Many of the DApps, even if developed by a centralized entity, are powered by open-source software. This is part of the value system that is prevalent throughout cryptocurrency.

Governments

DeFi is starting to garner a lot of attention from governments around the world. The challenge for them is in the name: decentralized.

If an application is truly decentralized while being tied to a blockchain, there is little that a government can do. Since much of this is open source, it is possible many versions of the same application pop up.

Without a centralized entity, there is nobody to check identities of users. This means KYC/AML is completely useless. Governments want to know who are using financial systems and where money is being sent. DeFi makes this rather difficult to follow.

There is also the issue with taxes. Much of this offers psuedo-anonymity. While the information can be read by anyone using a block explorer, the owner behind the wallet is not always known. Since there is no identification required when signing up, it is possible for the wallet user to be completely unknown.

All this makes regulation almost impossible. Government excel when there is a company or individual to go after. So far, they are coming up empty. One tactic they are starting to employ is to go after the developers.

In August 2022, Dutch authorities arrested Alexey Pertsev in relation to the development of Tornado Cash. This is a coin mixer which authorities claim was used to conceal criminal activities including crypto hacks. It got to the point where the US Treasury sanctioned the application and the wallets tied to it.

This is the cat and mouse game that is being played. DeFi introduces a layer of difficulty for governments intent on having their hands in the entire monetary and financial system.

Threat To Traditional Finance

Banks and other financial institutions have built a system where they are firmly integrated in all that occurs. In addition to banks controlling the monetary ledger, we see brokerage firms involved in the buying and selling of securities. Investment banks are the ones who are given responsibility for bringing new financial products to market. Wall Street is firmly in control of the financial sector, taking a cut of all that transpires.

DeFi looks to eliminate this. While it is still lacking in infrastructure, we are now seeing the potential for many of these entities to be eliminated. Most securities can be tokenized and operate tied to a blockchain system. Hence we have a situation where users will be able to store a synthetic asset in a wallet just like any other token or coin.

Another advantage to DeFi is the fact it was built in the digital world. The overhead for these organizations is minimal. If we compare the cost to running an application versus the cost structure of an investment bank, it gets ridiculous. We also have the fact this all comes under FinTech, something that wrought a great deal of damage on the traditional banking sector over the last 20 years.

DeFi Requires Responsibility

DeFi is not without risks. Some that many point to is the fact a number of large scale hacks took place. It is not uncommon for liquidity pools to be drained after the smart contract was compromised.

In addition to this, there is impermanent loss due to the fact that an investor in the pool is putting up two tokens or coins, in equal amounts. If there is a run on one, overall can end up as a losing position if the remaining one sees a drop in price.

Perhaps the biggest risk is the fact that the individual is solely responsible. Without a 3rd party, access to the wallet is only achieved through the private key. Lose that and all in the wallet is lost. There also will be an issue if the key is mistakenly revealed to people.

Since DeFi is mostly unregulated with a great deal of anonymity, there is little recourse if something does happen. This is why each person has to be mindful of what he or she is doing at all times.

Finally, there is no insurance or anything such as FDIC like with the banking system. Over time, DeFi projects might approach this but, as of now, individuals are on their own with this.

Proponents of DeFi feel this is the price to pay for freedom away from the centralized entities of control. For this reason, each person needs to think of him or herself as a custodian for the assets. This is something that some banks are starting to look at addressing, setting up platforms to host digital assets on behalf of their clients.

This might end up with a hybrid solution for a while.

DeFi Will Be In Everything

One of the main tenets of Web 3.0 is the idea that we are going to see the tokenization of everything, at least online. This means that every application and game has the potential to be its own economy.

Another factor in this is the idea of these being tied to decentralized databases and wallets. Ownership is much discussed with assets being tradable outside the individual app or game. This is exactly what proponents are DeFi have discussed for years.

As more tokens are issued, we are likely to see even more services offered by the different platforms. Wallets, DEX, collateralization, and a host of other financial ecosystems are going to cater to these users.

We are going to see non-fungible tokens (NFTs) becoming a part of the discussion also. These are going to present people with ownership rights, something that can be leveraged into other financial gains.

This appears to be a natural evolution of the Internet.

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