What is DeFi?
DeFi (pronounced dee-fye) is short for decentralized finance. It is an umbrella term for that part of the crypto universe that aims to build a new, internet-native financial system that uses blockchains to replace traditional intermediaries and trust mechanisms.
I am falling asleep.
Not! I promise it’s interesting.
OK, I’ll give him a chance. What do you mean by “using blockchains to replace traditional intermediaries and trust mechanisms”?
Let’s go back a little. To send or receive money in the traditional financial system, you need intermediaries like banks or stock exchanges. And in order to feel comfortable completing the transaction, all parties must be able to trust that these intermediaries are dealing fairly and honestly.
In DeFi, these middlemen are replaced by software. Instead of trading through banks and exchanges, people trade directly with each other, with blockchain-based “smart contracts” doing the work of creating markets, transacting trades, and ensuring the entire process is fair and trustworthy.
So is DeFi crypto’s version of an exchange?
That’s part of it. But DeFi also includes things like lending platforms, prediction markets, options, and derivatives.
Basically, crypto folks are building their own version of Wall Street – one that’s largely decentralized and deals exclusively in crypto, with crypto versions of many products offered by traditional financial firms, and without a lot of red tape and regulation that the Wall Street regulate existing financial system.
Wild West Wall Street! OK, now I’m interested. How big is DeFi?
The total locked value of DeFi, or TVL — a standard way of measuring the value of crypto in DeFi projects — is currently around $77 billion, according to DeFi Pulse. That would make DeFi something of the 38th largest bank in the United States by deposits if it were a bank.
So not huge, but not small either.
To the right. And TVL isn’t the only way to measure DeFi’s growth. You can also look at trading activity on decentralized exchanges, which have grown by triple-digit percentages over the past year.
Or you could take inspiration from regulators and politicians who are increasingly concerned about DeFi’s growth. Michael Hsu, the Acting Comptroller of the US Treasury, said in a speech at a blockchain conference in September that many DeFi products reminded him of the credit default swaps and other complex derivatives that were popular on Wall Street in the pre-2008 years financial crisis.
And Sen. Elizabeth Warren, the Massachusetts Democrat, singled out DeFi in a crypto hearing in December, calling it “the most dangerous part of the crypto world.”
Why are people so worried about DeFi?
In short, because DeFi is largely unregulated, with few of the 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. Stablecoins are cryptocurrencies whose value is pegged to the value of a government-backed currency like the US dollar.
Stablecoins are a critical part of DeFi markets because when you are a crypto investor, you don’t want to be constantly tokenizing back and forth into dollars or holding all of your assets in cryptocurrencies, which values can fluctuate wildly. You want a crypto coin that behaves like a boring, stable dollar that you can use without having to interact with the TradFi system at all.
It’s what the DeFi folks jokingly refer to as traditional finance.
Smart. So back to stablecoins. What is dangerous about them?
Well, regulators have argued that despite the name, stablecoins aren’t really that stable.
As my colleague Jeanna Smialek explained in an article on stablecoins last year, the concern stems from the fact that stablecoin issuers are not legally required to back their coins one-for-one with secure, cash-like assets. Investors who buy stablecoins can reasonably assume that each USD coin or tether (the two most popular stablecoins pegged to the US dollar) is worth $1 and that they can redeem their stablecoins for actual dollars at any time.
But currently there is nothing in the law that requires stablecoin issuers to have one-to-one support. And if they don’t have enough reserves to cover the stablecoins they’re issuing, the whole thing could collapse if enough investors decide to withdraw their money at once.
That sounds bad!
That would be it, especially since stablecoins are the backbone of DeFi trading. And there are questions among investors and regulators as to whether some of the top stablecoin issuers actually have enough assets to pay off their holders in the event of a large-scale redemption.
So stablecoins may not be stable. What else is potentially worrying about DeFi?
Also of concern are the crypto firms that issue loans, credit cards, and savings accounts without many of the protections or safeguards offered by traditional banks. Regulators in the United States have started cracking down on companies that release these products, saying they could pose a risk to consumers.
Regulators are also looking into decentralized exchanges, or DEXs, which allow users to trade crypto tokens using market-making algorithms.
And then there are all the hacks and scams…
Yes. DeFi, like crypto in general, is a big target for fraud. According to a report by blockchain analytics firm Elliptic, more than $10 billion was lost to hacks and fraud in DeFi projects in 2021 alone.
Typically, there is not much recourse for victims of DeFi scams. And unlike deposits at a regular bank, which are insured by the FDIC, crypto tokens typically cannot be replaced or restored once they are gone.
Let me get this straight. One of the fastest growing areas of crypto is a Wild West version of Wall Street, where there is no investor protection, where things called “stablecoins” may not be stable, and where your money could be irrevocably stolen at any time ?
That’s an unflatteringly worded but broadly accurate summary!
Why would anyone sign up for this?
First, many people like DeFi there it’s so new and unregulated. Building an entirely new financial system from the ground up is an intellectual challenge that doesn’t come around every day, and many people are drawn to the wide-open, uncharted potential of the sector. Additionally, if you are a savvy trader or a seasoned financial engineer, you could do all sorts of things in DeFi that you couldn’t do in the traditional financial system and potentially make a lot of money very quickly.
Second, many DeFi fans argue that blockchains are technologically superior to the existing banking system, much of which runs on old databases and outdated code. (Most banking transactions, for example, still rely on programs written in COBOL, a programming language from the 1960s.) Crypto, they say, is the first form of money actually developed for the Internet, and it’s growing , it will require a new internet-based financial system to support it.
Third, if you’re committed to the Crypto/Web3 vision of a decentralized economy, DeFi is the financial architecture that enables all the things you excite. In the traditional financial system, there is no way for a DAO to create a membership token from scratch and use it to raise millions of dollars. You cannot call JPMorgan Chase or Goldman Sachs and ask them to give you an offer for Smooth Love Potion denominated in Dogecoin. (Well, you could, but they could commit you.) But with DeFi platforms, you can find people willing to trade almost any crypto asset for almost any other crypto asset, without the need for approval from a central body .
And fourth, there is a more idealistic group of DeFi fans who see all of this in a much more utopian direction.
Financial decentralization, these people say, could help fix the flaws in our current financial system, in part by eroding the power of the big Wall Street banks over our economy and our markets.
How would that work?
These optimists claim that by replacing human intermediaries and trust mechanisms with public blockchains and open-source software, DeFi is cheaper (fewer fees), more efficient (faster transaction times), and more transparent (less opportunity for corruption) than the traditional financial system.
They say it democratizes investing and gives people tools that previously only professional investors had access to. And because you can participate in crypto anonymously and without a bank’s approval, they say DeFi is a way to provide financial services to people who aren’t well served by the conventional banking sector and avoid many of the discriminatory practices that have persisted among minorities prevented access to financial services in the past.
Ultimately, the optimists say, over time, DeFi will become more secure and resilient as more people adopt it and some of the early issues are ironed out. And just as they believe web3 will replace greedy technology platforms with user-owned collectives, they believe DeFi will replace today’s banks and brokers with a better, fairer system.
That sounds great, but I’m still concerned. Didn’t we learn our lesson about the dangers of unregulated finance in 2008? Could DeFi bring about the next financial crisis?
For now, DeFi is unlikely to create any catastrophes 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 of the overall economy), and many of the people pouring money into DeFi are the kind of deep-pocketed investors who could absorb big losses themselves.
But the possibility that DeFi could grow big enough to pose systemic risk hasn’t escaped regulators’ efforts to make the crypto’s Wild West a little less wild.
“Finance 3.0: DeFi, Dapps, and the Promise of Decentralized Disruption” Kevin Werbach, a professor at the University of Pennsylvania’s Wharton School, argues that DeFi will revolutionize finance by “eliminating costly and controlling intermediaries from financial transactions.”
“Has anyone seen Tether’s billions?” Bloomberg’s report on Tether’s mysterious dollar reserves, the stablecoin at the heart of the DeFi economy, helps explain why regulators are concerned.
“The Defiant” This independent media outlet’s daily DeFi newsletter is a must-read for the industry.